In this chapter, you will learn to: Describe the role of financial intermediaries, differentiate between bonds and stocks and show why their prices are inversely related to interest rates, explain how the financial system improves the allocation of saving to productive uses, discuss the three functions of money and how the money supply is measured, analyze how the lending behavior of commercial banks affects the money supply, explain how the central bank controls the money supply and its relation to inflation in the long run.
Money, Prices, and the Financial System Chapter 20 McGrawHill/Irwin Copyright © 2015 by McGrawHill Education (Asia). All rights reserved 201 Learning Objectives Describe the role of financial intermediaries such as commercial banks in the financial system Differentiate between bonds and stocks and show why their prices are inversely related to interest rates Explain how the financial system improves the allocation of saving to productive uses Discuss the three functions of money and how the money supply is measured Analyze how the lending behavior of commercial banks affects the money supply Explain how a central bank controls the money supply and how control of the money supply is related to inflation in the long run 202 Money in Economics • • The term "money" in economics has a specific meaning different from every day use To an economist: – – – – Your paycheck is income The income you don't spend is saving The increase in the value of your stock is a capital gain When your house appreciates, your wealth increases 203 The Allocation of Saving • • • A successful economy allocates its saving to the most productive investments The interest on deposits is one important reason people put their saving in banks The financial system improves the allocation of saving: – – Provides information to savers about the possible uses of their funds Help savers share the risks of individual investment projects • Risk sharing makes funding possible for projects that are risky but potentially very productive 204 Banking System • Financial intermediaries are firms that extend credit to borrowers using funds raised from savers – – Thousands of commercial banks accept deposits from individuals and businesses and make loans Banks and other intermediaries specialize in evaluating the quality of borrowers • • • Principle of Comparative Advantage Banks have a lower cost of evaluating opportunities than an individual would Banks pool the saving of many individuals to make large loans 205 Banking System • Banks gather information about potential investments – – – • Banks provide access to credit for small businesses and homeowners – • Evaluate the options Direct saving Service provided to depositors May be the only source of credit for some investments When banks make loans, they earn interest which, in turn, is paid to the bank's depositors 206 The Banking System • Having bank deposits makes payments easier – – – • • Checks ATMs Debit card Checks and debit cards are safer than cash Banks provide a record of your transactions 207 Japanese Banking Crisis, 1990s • Japanese banks fell into severe trouble – – • Property values decreased and some loans on real estate went into default Banks held stocks and the stock values decreased Japan had relied on banks to allocate its saving – – – – Thin financial markets Borrowers had difficulty obtaining credit Small- and medium-sized businesses suffered Credit shortages prolonged the recession as businesses struggled to fund new projects 208 Bonds • • A bond is a legal promise to repay a debt Each bond specifies – – Principal amount, the amount originally lent Maturation date, the date when the principal amount will be repaid • – – The term of a bond is the length of time from issue to maturation Coupon payments, the periodic interest payments to the bondholder Coupon rate, the interest rate that is applied to the principal to determine the coupon payments 209 Bonds • • Corporations and governments issue bonds The coupon rate depends on – The bond's term • – The issuer's credit risk • • – 30 days to 30 years; longer term, higher coupon rate Probability the issuer will default on repayment Higher risk, higher coupon rate Tax treatment for the coupon payments • • Municipal bonds are free from federal taxes Lower taxes, lower coupon rates 2010 ... interest rate 20 11 Selling a Bond Offer for sale: one government bond with payment of $1,050 due in one year • The competition: a new one-year bond with principal of $1,000 and coupon rate of 6% –... evaluating the quality of borrowers • • • Principle of Comparative Advantage Banks have a lower cost of evaluating opportunities than an individual would Banks pool the saving of many individuals... controls the money supply and how control of the money supply is related to inflation in the long run 20 2 Money in Economics • • The term "money" in economics has a specific meaning different